What Is Momentum Trading?

Momentum trading is a technique in which traders buy and sell according to the strength of recent price trends. Price momentum is similar to momentum in physics, where mass multiplied by velocity determines the likelihood that an object will continue on its path. In financial markets, however, momentum is determined by other factors like trading volume and rate of price changes. Momentum traders bet that an asset price that is moving strongly in a given direction will continue to move in that direction until the trend loses strength.

Where Did Momentum Trading Start?

The practice of momentum trading has been around for centuries. As early as the late 1700s, famed British economist and investor David Ricardo was known to have used momentum-based strategies successfully in trading. He bought stocks with strong performing price trends, and then sold stocks whose prices were performing poorly. He characterised the method with the phrase: "Cut short your losses; let your profits run on."[1]

Following the development of technical analysis in the late 19th century, notions of momentum gained use in the 1920s and '30s by well-known traders and analysts such as Jesse Livermore, HM Gartley, Robert Rhea, George Seaman and Richard Wycoff.[2]

The notion was first formalised in academic studies in 1937 by economists Alfred Cowles and Herbert Jones. They found that assets that performed well in one year tended to continue to perform well in the following year.[3]

However, the concept was obscured and left dormant following the development and popularisation of value investing theory from the 1930s onward. Investors would focus more on the intrinsic, or "fundamental," value of an asset, and less on the trajectory of the movement of its price.

Following a renaissance of technical analysis later in the century, the concept of momentum investing enjoyed a revival with the publication of a study by Jegadeesh and Titman in 1993. It showed that traders and markets tended to give positive feedback to recent information about asset prices, thus reinforcing price trends as they are in effect.[4]

Relative Momentum And Absolute Momentum

Momentum trading can be classified in two categories: Relative momentum and absolute momentum.

Relative momentum strategy is where the performance of different securities within a particular asset class are compared against one another, and investors will favour buying strong performing securities and selling weak performing securities.

Absolute momentum strategy is where the behaviour of the price of a security is compared against its previous performance in a historical time series.

In currency trading, either relative or absolute momentum can be used. However, momentum trading strategies are more frequently associated with absolute momentum.[5]

How Is A Momentum Strategy Employed?

Momentum can be determined over longer periods of weeks or months, or within day-trading time frames of minutes or hours.

The first step traders customarily take is to determine the direction of the trend in which they want to trade. Using one of several momentum indicators available, they may then seek to establish an entry point to buy (or sell) the asset they are trading. They will also want to determine a profitable and reasonable exit point for their trade based on projected and previously observed levels of support and resistance within the market.

Additionally, they are recommended to set stop-loss orders above or below their trade entry point—depending on the direction of the trade. This is in order to safeguard against the possibility of an unexpected price-trend reversal and undesired losses.

Momentum Indicators

The momentum indicator is a common tool used for determining the momentum of a particular asset. They are graphic devices, often in the form of oscillators that can show how rapidly the price of a given asset is moving in a particular direction, in addition to whether the price movement is likely to continue on its trajectory.

The notion behind the tool is that as an asset is traded, the velocity of the price movement reaches a maximum when the entrance of new investors or money into a particular trade nears its peak. When there is less potential new investment available, the tendency after the peak is for the price trend to flatten or reverse direction.

The direction of momentum, in a simple manner, can be determined by subtracting a previous price from a current price. A positive result is a signal of positive momentum, while a negative result is a signal of a negative momentum.

Momentum tools typically appear as rate-of-change (ROC) indicators, which divide the momentum result by an earlier price. Multiplying this total by 100, traders can find a percentage ROC to plot highs and lows in trends on a chart. As the ROC approaches one of these extremes, there is an increasing chance the price trend will weaken and reverse directions.[6]

Here are a few of the technical indicator tools commonly used by traders to track momentum and get a feel for whether it's a good time to enter or exit a trade within a trend.

Moving averages: These can help identify overall price trends and momentum by smoothing what can appear to be erratic price movements on short-term charts into more easily readable visual trend lines. They're calculated by adding the closing prices over a given number of periods and dividing the result by the number of periods considered. They can be simple moving averages, or exponential moving averages that give greater weight to more recent price action.

Relative strength index (RSI): As the name suggests, it measures the strength of the current price movement over recent periods. The aim is to show the likelihood of whether the current trend is strong in comparison to previous performance.

Stochastics: The stochastic oscillator compares the current price of an asset with its range over a defined period of time. When the trend lines in the oscillator reach oversold conditions—typically a reading of below twenty—they indicate an upward price momentum is at hand. And when they reach overbought conditions—typically a reading of above 80—they indicate that a downward price momentum is ahead.

Moving average convergence divergence (MACD): This tool is an indicator that compares fast- and slow-moving exponential moving price average trend lines on a chart against a signal line. This reveals both price momentum and possible price trend reversal points. When the lines are farther apart, momentum is considered to be strong, and when they are converging, momentum is slowing and price is likely moving toward a reversal.

Commodity channel index (CCI): This momentum indicator compares the "typical price" of an asset (or average of high, low and closing prices) against its simple moving average and mean deviation of the typical price. Like stochastics and other oscillators, its aim is showing overbought and oversold conditions. Readings above 100 indicate overbought conditions, and readings below 100 indicate oversold conditions.

On balance volume (OBV): This momentum indicator compares trading volume to price. The principle behind it is that when trading volume rises significantly without a large change in price, it's an indication of strong price momentum. And if volume decreases, it's understood as a sign that momentum is diminishing.

Stochastic momentum index (SMI): This tool is a refinement of the traditional stochastic indicator. It measures where the current close is in relation to the midpoint of a recent high-low range, providing a notion of price change in relation to the range of the price. Its aim is to provide an idea of a reversal point is nearby, or if the current trend is likely to continue.

Average directional index (ADX): This simple oscillator tool aims solely at determining trend momentum. It plots the strength of a price trend on a graph between values of 0 and 100: values below 30 indicate sideways price action and an undefined trend, and values above 30 indicate a solid trend in a particular direction. As the value approaches 100, the momentum of the trend is understood to grow stronger.

Building block: In this technique, traders divide an existing chart into equal periods, separated in blocks. The blocks are then color-coded according to whether they indicate an upward trend or a downward trend; for example, green for upward and red for downward. A third color, yellow, could be used to indicate a sideways trend. If the chart shows two consecutive blocks with the same color, then it indicates that there is momentum in a given direction.

Risks To Momentum Trading

Like any style of trading, momentum trading is subject to risks. It's been found to be successful when prices follow on a trend, but on occasion momentum traders can be caught off guard when trends go into unexpected reversals. Traders should remember that:

Technical analysis bases its projections of the probability of price movements on past price trends.

Prices in the market can move in an unforeseen manner at any time due to unexpected news events, or fears and changes in sentiment in the market.[7]

Summary

Momentum is a key concept that has proven valuable for determining the likelihood of a profitable trade. Measurements of momentum can be used in the short and long term, making them useful in all types of trading strategies. Several technical trading tools are available to reveal the strength of trends and whether a trade on a particular asset may be a good bet.

However, traders should be forewarned that momentum projections are customarily calculated using measurements of past price trends. Actual momentum and price can change at any moment based on events that weren't factored into the original calculations. Because of this, it's important to take preventative measures, such as setting stop-losses, to safeguard against unforeseen price reversals in even the most probable momentum scenarios.

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